Regulatory and Compliance Intersection of Investment Advisors to Small Business Investment Companies and Private Fund Advisors

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Background

A Small Business Investment Company (“SBIC”) is a privately owned and operated company that makes long-term investments in American small businesses and is licensed by the U.S. Small Business Administration (the “SBA” or “Administration”). The SBA conducts the SBIC Program through its Investment Division, located in Washington, D.C. The SBIC Program encourages the creation of SBIC funds to increase the flow of investment capital to small businesses and smaller enterprises in the United States. A discussion of the application process and requirements to become an SBIC is beyond the scope of this article. For further information on the application and licensing process, please refer to the SBA website.

It is common for a private fund (“PF”) manager to own and operate an SBIC fund(s). The principal reason for a PF manager firm to become licensed as an SBIC is access to financing (leverage) provided by the SBA. Fund managers typically form SBIC funds as limited partnerships (“LPs”) managed by a general partner, and the limited partnership interests are offered to accredited investors. Additional benefits include:

  • Concentration of a large portion of funding in one LP reduces fundraising burdens and administrative / reporting requirements,
  • Enhanced deal sourcing through a network of SBICs, and
  • SBA’s financial reporting criteria help SBICs develop standardized and comprehensive investor relations processes.

Regulation

U.S. Small Business Investment Act of 1958

SBICs are regulated under the U.S. Small Business Investment Act of 1958 and licensed by the SBA. SBICs are subject to multiple investment restrictions and requirements, including prohibitions on certain types of investments and diversification requirements.

Investment Advisers Act of 1940 (“Advisers Act”)

Under the Advisers Act, there are 3 exemptions from SEC registration available to SBIC advisors:

SBIC Advisor Exemption – An advisor that solely provides advice to an SBIC licensed by the SBA is exempt from registration as an advisor and the requirements attendant to registration (e.g., reporting and recordkeeping).

Compliance Tip – The SBIC advisor is required to have appropriate policies and procedures and is subject to a regulatory review no less than every two years by the Office of SBIC Examinations. These examinations are designed to ensure SBIC funds operate in compliance with the SBIC regulations or determine those instances when they have failed to do so.

Private Fund Advisor Exemption – Available to an advisor solely to private funds that has less than $150 million in assets under management in the U.S., and one or more SBICs. Under this exemption, the assets of the SBIC(s) are excluded from the assets under management of the private fund manager. An advisor that has any other type of client is not eligible for this exemption. The SEC refers to this type of advisor as an exempt reporting advisor (“ERA”).

Compliance Tip – An advisor relying on the private fund advisor exemption must file an initial and annual report on Form ADV to the SEC and is subject to examination. Other provisions of the Act and SEC rules applicable only to registered advisors do not apply.

Venture Capital Fund Advisor Exemption – Available to an advisor that solely advises one or more “venture capital funds” as defined by SEC rule (regardless of the amount of assets managed), and one or more SBICs. The SEC refers to this type of advisor as an ERA.

Compliance Tip – An advisor relying on the venture capital advisor exemption must annually file a report on Form ADV to the SEC and is subject to examination. Other provisions of the Act and SEC rules applicable only to registered advisors do not apply.

Since PF and venture capital fund advisors relying on the referenced exemptions are deemed ERAs, these advisors must, in addition to meeting specific reporting requirements (i.e., Form ADV) and general recordkeeping requirements, comply with other Advisers Act requirements including:

  • Fiduciary obligations,
  • Duty to supervise,
  • Pay-to-Play Rule,
  • Fraud against investors in pooled investment vehicles,
  • Insider trading policies and procedures, and
  • Whistleblower protections.

Overall, a PF manager advising SBIC funds is common and presents primarily ERA compliance risks until the manager registers with the SEC. Policies, procedures, and controls should address the fund managers investment, business, and operational activities, including accounting for a separate compliance program for an SBIC fund.

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